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Wednesday, June 15, 2016

Global Safe Yields Continue Their Downward March

So yields on Germany's 10-year government bonds have gone negative. Put differently, investors are now paying the German government to take and hold their funds for ten years! Manyareblaming this development on Brexit fears and the ECB's bond buying program. While this is a reasonable proximate explanation, the recent decline is part of a far bigger story: interest rates on safe assets across the world have been declining since 2008. This can be seen in the figure below.

This downward march of safe yields is a consequence of the safe asset shortage problem. What we are seeing in Germany is just the latest manifestation of it. What the above figure should make clear is that this safe asset shortage problem has been going on outside of QE programs and before central banks started doing negative interest rates. So don't blame central banks for the low interest rates.1

This downward march of safe yields across the globe is a big deal. It indicates the global economy needs more safe assets and lower interest rates to clear. However, at some point, the effective lower bound (ELB) will kick in and prevent rates from going lower. When that happens something else will have to adjust--output--and there will be a global race to the ELB. Here is Caballero, Fahri, and Gourinchas (2016) making this point:

In the open economy, the scarcity of safe assets spreads from one country to the other via the capital account. Net safe asset producers export these assets to net safe asset absorbers until interest rates are equalized across countries. As the global scarcity of safe assets intensifies, interest rates drop and capital flows increase to restore equilibrium in global and local safe asset markets. Once the ZLB is reached, output becomes the adjustment variable again.

In other words, be ready for more! If you think pension funds, banks, insurance companies are scrambling for yield now, you ain't seen nothing yet! More importantly, the Cabellero, Fahri, and Gourinchas analysis suggest a global growth slowdown is likely too.

So what are the solutions to the safe asset shortage problem? I will refer you again to the figure I used in my last safe asset post for the answers. My preferred solution is to try the 'shock and awe' approach to improve the economic outlook via a NGDP level target backstopped by Treasury.

1Though one can blame central banks for allowing us to get in this position in the first place. As I have argued elsewhere, the Fed and ECB could have done more to avoid the Great Recession. The did not and now the safe asset problem horse is out of the barn.

12 comments:

Housing. Nationwide, we need millions of homes. That is why there is a shortage of safe assets. This will require support for generous mortgage markets, which few are willing to accept. Until this changes, the current trends will continue.In the meantime, our major urban centers have repressive capital controls, implemented through housing policies, that provide outrageous returns on investment for insiders (existing owners) and outrageous political barriers to entry for new capital. Quantitatively, it is well into third-world territory, in terms of political barriers to capital allocation.I don't know why this isn't at the center of all discussions regarding falling real interest rates.

Your figure suggests that these are exclusive choices. That's of course not correct, I think the cartoon figure does not need to be so confused, as the correct answer is of course: take all of the directions, they're not mutually exclusive. Of course in the real world we're exactly like the cartoon figure, and keep looking confused and freezing, looking like a deer straight in the headlights.

We don't have a Safe Asset Problem. What we have is a distribution-of-income/saving problem.

I don’t know the numbers for the rest of the world, but when the share of the top 1% in the US went from 8% in 1980 to 19% in 2012, the share of the bottom 99% went from 92% to 81%. As a result, the bottom 99% of the income distribution—99 out of 100 families—had, on average, 12% less purchasing power from income relative to the output produced in 2012 than the bottom 99% had relative to the output produced in 1980, and as we go down the income scale the reduction in purchasing power from income became more dramatic.

In 2012 the bottom 90% of the population—9 out of 10 families—had, on average, 23% less purchasing power from income relative to the output produced in 2012 than the bottom 90% had in 1980 relative to the output produced in 1980. As a result, sustaining employment required an increasing dependence on an increasing debt/income ratio as I have explained here: http://www.rweconomics.com/htm/WDCh3e.htm )

The problem we face today is what Robertson referred to as “the long-period problem of saving” which I have tried to explain here: http://www.rweconomics.com/htm/LPLFLPPS.htm

Trying to solve this problem through monetary and fiscal policies that create safe assets without raising taxes at the top and on corporations and without reducing the trade deficit will do little more than prop up a system that transfers income from the bottom to the top. If that’s what people want, fine, but we should not ignore that this is what we are talking about. (See: http://rwEconomics.com/LTLGAD.htm )

From what I can deduce from Credit Suisse’s “Global Money Notes #5” (you can find it via Google) Basle III’s has added a “Liquidity Coverage Raito” requirement that forces banks to hold ‘safe’ (liquid) assets in proportion to their risky assets in an attempt eliminate future liquidity crises. This would appear to be an attempt to force banks to return to the practices of the fifties, sixties, and seventies when banks held a large portion of their assets in government debt and there were no financial crises that required bailouts.

The result of this requirement has made it difficult for regular bands to fund shadow banks for lack of the safe assets needed to cover loans to shadow banks—hence the safe-asset problem. There seems to be a belief that this is somehow related to low and negative interest rates in that the reason for low and negative interest rates is the increasing demand for safe assets caused by the Basel III requirement. I think this is a serious mistake.

It seems quite clear to me that the problem of low and negative interest rates on safe assets stems from the fact that consumer demand is insufficient to provide the real investment opportunities needed to generate full employment. As a result wealth holders seek alternative ways to store their wealth and in so doing they seek out the safest assets they can find. In other words, what we are seeing here is the result of “secular stagnation, savings glut, and debt overhang” etc., not the cause of these problems. Creating more safe assets is not going to solve the fundamental problem we face. All it will due is prop up a collapsing system. See http://www.rweconomics.com/htm/LPLFLPPS.htm and http://rwEconomics.com/LTLGAD.htm .

George, Basel III is part of the story but not the only one. The sudden downward acceleration of yields starting in 2008 speaks to lasting effect of the crisis and subsequent bad news shocks (never ending Eurozone crisis, fiscal cliff, China concerns, political uncertainty, etc.)

“This downward march of safe yields across the globe is a big deal. It indicates the global economy needs more safe assets and lower interest rates to clear. However, at some point, the effective lower bound (ELB) will kick in and prevent rates from going lower. When that happens something else will have to adjust--output--and there will be a global race to the ELB.”

But I do not agree with Credit Suisse that Basle III plays an important role in what’s going on here. I also do not agree that a “'shock and awe' approach to improve the economic outlook via a NGDP level target backstopped by Treasury” is a viable solution to this problem.

What we are witnessing today is a massive, world-wide increase in the demand for liquidity for want of better alternatives as a store of wealth. The problem is not the lack of liquid assets to meet this demand. The problem is the lack of profitable real-investment opportunities as a viable alternative to storing accumulating wealth in the form of liquid assets.

As I try to explain in http://www.rweconomics.com/htm/WDCh3e.htm , the fundamental cause of this problem is the increase in the concentration of income that has taken place over the past thirty years, and as I try to explain in http://rwEconomics.com/LTLGAD.htm , trying to solve this problem through monetary and fiscal policy alone is unsustainable so long as these policies increases debt relative to income without reducing the concentration of income.

This is the kind of situation we faced in the 1930s. Monetary and fiscal policy propped up the system following 1933 along with the concentration of income, but the problem itself was not solved until World War II came along, the government completely took over the economic system, and the concentration of income fell dramatically. ( http://www.rweconomics.com/htm/WDCh3e.htm )

Hansen understood this problem in terms of the lack of investment opportunities when he gave his address on secular stagnation in 1938 as did Samuelson when he included consumption as the motivator of investment in the accelerator process. But neither Hansen or Samuelson them thought in terms of the connection of income. As a result, the relationship between the fall in the concentration of income that took place during World War II and the prosperity that followed was not understood by economists.

Keynes understood this problem (which Robertson dubbed “the long-period problem of saving”) both implicitly and explicitly. He analyzed it throughout the General Theory, and he saw clearly that it could not be solved through monetary policy alone. He also saw that it could not be solved in the long run (even if inequality were completely eliminated) simply by running fiscal deficits. ( http://www.rweconomics.com/htm/LPLFLPPS.htm )

It seems quite clear to me that it does not bode well for the future if economists continue to offer only abstract solutions to the problems we face today that attempt to deal with them indirectly while ignoring what Keynes had to say about the long-period problem of saving in Chapter 24 of The General Theory of Employment, Interest, and Money. To deal with this problem rationally we need concrete solutions that attempt to deal with this problem directly. ( http://www.rweconomics.com/htm/LPLFLPPS.htm and http://rwEconomics.com/LTLGAD.htm )

Our own logic has been tripping us up for almost forty years: evidence since 1980 indicates that long-term increasing wealthy inequality leads to long-term declines in aggregate demand (purchasing power). Investors react to this in a flight to safety; businesses react by cutting back on capital investment; central banks react by continually lowering nominal rates; consumers react by saving more when they can't get credit. Clearly, all of these reactions are mutually reinforcing. The only 'winner' in all of this, if you want to call it that, are the asset markets, where the wealthy are able to park their cash in an apparently semi-liquid form and continue to get returns that beat inflation. The way out, I must believe, is non-economic, in that it will probably not 'make sense' from a textbook finance perspective.